Due to the current economic uncertainty resulting from the ongoing COVID-19 pandemic, it is more important than ever to understand the tax impacts of a downturn. Appropriate financial preparation for recessionary impacts from a tax perspective can be imperative in surviving such an economic climate.
QUALIFIED BUSINESS INCOME (QBI) DEDUCTION
Effective beginning in 2018 was the 20 percent qualified business income deduction, which has had a positive tax impact for those contractors that have maintained good financial standing. One aspect of this deduction that has been overlooked is that losses from sources generating QBI can reduce the current year deduction to zero. Any unused negative QBI must be carried forward to the following year. Business owners and management need to be cognizant of the effects of a QBI loss and its negative effect on potential deductions, until the deduction is no longer effective post-2025. As of the effective date of this deduction these QBI losses must now be tracked by all related companies.
NET OPERATING LOSSES (NOL)
During economic downturns like the 2008 recession, contractors faced large losses, but were allowed to carry back current year losses, effectively recovering amounts paid for prior period taxes. This is no longer a tax advantage that can be leveraged due to the enactment of the 2017 Tax Cuts and Jobs Act (TCJA). This act repealed prior tax guidance related to NOLs, which allowed NOLs to be carried back two years, with any excess carried forward for 20 years. In addition, this act also allowed taxable income to be offset completely. Now due to the issuance of the TCJA for tax years ending December 31, 2017 taxable income can only be offset by 80 percent, and cannot be carried back, but can be carried forward indefinitely. Companies are now also required to track pre-2017 and post-2017 NOLs separately to ensure proper application of these amounts.
BUSINESS LOSS LIMITATIONS
In addition to the provisions related to NOLs changing the ability to use losses in prior and future years, there is also a limitation related to the use of losses in the current year. For tax years beginning after December 31, 2017, losses are subject to loss limitation, which is calculated by taking the excess of a tax payer’s total deductions over income attributable to a trade or business plus $500,000 for married taxpayers filing jointly and $250,000 for all other filers. The remaining loss is subject to NOL restrictions as mentioned above and only applies to passthrough entities calculated at the partner or shareholder level, this does not apply to C Corporations. It’s key for contractors to understand that losses can now only be applied to those generated by a trade or business (also referred to as non-passive activities). For contractors this would strictly be day-to-day operations. Prior to the implementation of the business loss limitation, businesses were able to offset losses against passive income sources such as capital gains or interest.
Another consequence to a contractor incurring losses, especially during a poor economic climate, is the need to obtain loan funding from financial institutions in an effort to generate cash for operations. The related business interest expenses attributed to this debt that can be deducted now have potential limitations for large contractors after the enactment of the Tax Cuts and Jobs Act (TCJA). Per guidelines of the TCJA, large contractors with average annual gross receipts in excess of $25 million will only be allowed to deduct business interest up to 30 percent of their adjusted taxable income. Adjusted taxable income is defined as net earnings before interest, taxes, depreciation, and amortization (EBITDA) plus any QBI deductions or NOL taken in the current year. All nondeductible interest expenses incurred above the limitation are carried forward indefinitely.
PERMISSIBLE TAX DEFERRALS
Normally tax deferrals are a means to reduce current year taxes and generate current year liquidity, but they can have reverse effects during a downturn. For instance, one tax deferral option available is the 10 percent method where contractors utilizing the percentage of completion method are allowed to defer the recognition of income from long-term contracts (until at least 10 percent of the estimated total contract costs have been incurred). During times of prosperity a contractor will typically have a significant number of new contracts that are below 10 percent complete allowing the contractor to offset prior year deferred revenue. Unfortunately, in a downturn a contractor will typically not see nearly the same number of new contracts as they would in a booming economy. In effect, prior year deferrals will not be able to be offset by those in the current year, which results in additional income that a contractor may not have anticipated taking on. Additionally, the 10 percent method is not the only type of tax deferral available to contractors and can include, but is not limited to the following:
In light of the ongoing COVID-19 pandemic, all of the aforementioned tax strategies are imperative to consider as the construction industry faces the likelihood of significant losses. Some of the tax advantages that existed during the last recession in 2008, such as carrying back current year losses to generate tax refunds, are no longer possible. In order to best prepare for what lies ahead, it is recommended that businesses actively track their contract losses and speak with their tax advisers to leverage current tax law to the best of their advantage.